Reflections from Omaha: A Case of Cognitive Dissonance

by Ben Claremon | Principal, Research Analyst

After taking a year off from partaking in the annual trek to Omaha, I returned to the home of The Oracle looking to be re-invigorated. There is so much noise and nonsense that surrounds the investment management industry that I find it valuable to spend a weekend being constantly reminded of the core value investing principles. But this year I left Omaha with somewhat of an empty feeling. It was as if the weekend was tainted by a not-so-obvious contradiction that I couldn’t quite reconcile.

As a brief reminder, before moving to Los Angeles I lived in New York and worked for a couple of different hedge funds there. Even though my tenure was cut short by the financial crisis, I consider myself to have been raised within the New York City investment culture. As such, many of my friends run hedge funds and most of the asset allocators I know spend the majority of their time looking for the next hot hedge fund manager. This was—and still is—a world characterized by suits (with no tie of course), high fees, shorts (not the ones we wear on Fridays at Cove), and the bravado that is a result of being viewed as a modern-day master of the universe.

Being many years removed from my New York experience—and after 6 years of generally desultory performance by the hedge fund world—I was simply astounded to see how much mindshare is still taken up by hedge funds. Omaha was crawling with old hedge funds, new hedge funds looking for money, people heavily invested in hedge funds, and people looking to allocate to hedge funds. I have no idea why I felt “junior” to this crowd given that I am a partner in a long-only firm with a billion dollars under management that has superb short- and long-term performance over…20 years. But there I was the only poor sap who didn’t run or work for a fund.

So is it all optics? Or is nearly everyone who attends the Berkshire annual meeting really smarter than us and thus the hedge fund mystique is really grounded in facts and performance? The benefits of indexing, low fees and full transparency are in the news every day. So I began to wonder why these facts don’t apply to these people. And why were they there to listen to Warren and Charlie chew them out again? In case you missed it, here is a summary of what the Wall Street Journal called an epic rant against Wall Street. The irony here is that so many of the people who fly thousands of miles to see Warren and Charlie pontificate operate precisely the type of investment firms for which Buffett has such a distaste. It’s as if everyone thinks he is talking about those other guys. There is definitely some modicum of the Lake Woebegone Effect going on here. The people who manage the money think they will inevitably earn their high fees and the people who allocate the money believe they can identify those who deserve such compensation. It is a very well documented fact that these statements are not borne out by the facts.

But Ben, what about Buffett’s famous “The Superinvestors of Graham-and-Doddsville” article? Aren’t value investors more likely to outperform over the long-run? Isn’t this a group of people that shuns short-termism and chaotic trading? Umm…some; but certainly not enough for seemingly everyone to be charging 2 and 20.

And that is the rub. There is simply a tiny percentage of managers who are truly that gifted, and that can and should command the “you want in, pay up” access for this expertise. That being said, unlike Buffett, I don’t have any specific bone to pick with hedge fund managers and consultants. There are many ways to run money successfully and I believe that, over time (and as we all know, it can be a REALLY long time), the market will sort out the wheat from the chaff. If the clients are willing to pay the substantial cost of admission, who am I to criticize the manager? As Austin Powers so eloquently said when he learned that the communists had lost the Cold War, “yay capitalism.” What I do know is that it is a lot harder to compound your clients’ wealth when you take a substantial percentage of the gains. I also know that it is your investment process and temperament that lead to superior results—not how you choose to structure your firm or the fees you charge.

Back at Cove Street world headquarters, we operate a long way from the New York hedge fund cluster and I think it really helps. I wear sneakers to work; my office is filled with graffiti as opposed to wood paneled walls; and yes, a couple of times a month I bring my Pomeranian to work with me.

While only a little bitter about our seeming inability to raise the last few hundred million in our small cap strategy—ostensibly because of our fees (lower) and structure (simpler)—we remain defiant in our contrarianism and independent thinking. While clearly not household knowledge, there are distinct advantages to a long-only structure. We don’t short, an activity that is widely talked about, but has very little data supporting its additive nature to performance. We don’t feel compelled to sell our stocks and go to cash to protect our high water mark—and our ability to retain employees. We don’t “manage” volatility; we take advantage of it. We can buy stocks on the way down and sell them on the way up. We can take advantage of the very real time premium and not worry about a down month resulting in clients putting us on notice.

This un-sexy, get-rich-slowly mentality has allowed Warren Buffett to accumulate tens of billions of unrealized gains in stocks he has held for decades—and become one of the richest people in the world despite forsaking performance fees many years ago. And if long-only managers are a dying breed, we are just fine being one of the last managers standing.

I will close with some thoughts on the industry from John Phelan, who runs MSD—Michael Dell’s investment firm. This is what he said as part of an incredibly interesting interview in the Spring 2016 Graham-and-Doddsville newsletter:

If you applied Porter’s Five Forces to the hedge fund industry right now, I’m not sure that analysis would suggest you should go running in. You’ve got massive fee pressure, so revenues are coming down. You have huge regulatory costs and burdens plus IT expenses which seem to go up every year, so your costs are going up. You could argue the barriers have gotten bigger because of the expense of starting, but when you look at the number of hedge funds each year that seem to start and go out of business, even post-2008, you would have thought there would be a significant drop in the number of firms and assets. But we did not see that. When I compare the number of firms today run by smart people compared to when I started, it is mindboggling. I also think you have a massive asset-liability mismatch caused by institutional investors, making it that much harder to succeed long term. If you look at what investors want today, I call it the Holy Grail: liquidity, transparency, high returns, low volatility, and group validation. The question is this: Is this goal achievable? Does it make sense? The only person I can think of who consistently gave you this is Madoff.

My partner—who is also Cove Street’s founder—has a consistent mantra that bears repeating right now. We pursue strategies that: make intellectual sense, in which we have a reasonable degree of demonstrated competence, and that someone else besides ourselves appears to give a damn about. Sadly, I think I am a little less confident in the last part after being in Omaha.

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